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The issues aren’t quite the same as those one faces when considering the deepest aspects of personal faith and religious doctrine, but a “Roth conversion” can pose some difficult issues for investors nonetheless. And we’re going to hear much more about this going forward because of a scheduled change in the law: Unless something unexpected happens in D.C., come 2010 there will no longer be income limits on Roth IRA conversions.

There will be a lot written on the issue of whether one should convert or not, as well as endless articles describing all kinds of “strategies” to potentially leverage the change (some legitimate and others more questionable). For me, three things are important in considering this kind of “conversion”:

1. First and foremost is how strongly you feel about your future income tax rates. If you feel strongly that there is a significant chance your income tax rates will be higher in the future, then having some money in a Roth allows you to “hedge” that risk by paying taxes at today’s rates. Of course, you should note that while the Roth rules currently stipulate that no income taxes are owed on qualified Roth withdrawals, tax laws can change. So while the Roth clearly offers some protection from taxes, it’s not an ironclad guarantee.

2. Second is that you have to recognize that $1 of after-tax wealth is more than $1 of before-tax wealth. What this means is that by converting a $10,000 pre-tax IRA to a $10,000 post-tax Roth IRA, you have effectively put more resources into your IRA account. An example: If your income tax rate is 25%, your $10,000 pre-tax IRA is worth $7,500 of goods and services. Your $10,000 post-tax Roth is worth $10,000 of goods and services. In other words, even if the dollar amounts in traditional and Roth accounts are the same, the Roth gives you an ongoing tax break on “more” wealth. This is why, to properly compare the tax advantages of the two dollar-for-dollar, most quantitative analyses of Roth versus traditional—including Vanguard’s—include a taxable “balancing account” along with the traditional IRA. What you see is that if tax rates don’t change over time, the two IRAs actually offer identical tax benefits per dollar of after-tax IRA wealth. It’s just that you can generally get more after-tax wealth into a Roth. In practice, most people in the real world aren’t going to set up an additional savings account alongside their traditional IRA. So a Roth conversion is a great chance to save more, assuming you can pay the taxes you’ll owe on the conversion from a source other than the converted IRA.

3. A last consideration is how focused you are on spending the money in retirement. A big advantage of a Roth IRA is that you don’t have to take minimum distributions in your lifetime. That means you can keep the money in the “tax-free” wrapper a very long time. This is less of an advantage if you see yourself spending regularly from your IRA in retirement.

Obviously, everyone should consult a tax advisor about his or her own situation. But a Roth conversion in 2010 could offer some significant benefits to a lot of investors. And in all the noise and “strategizing” you’re going to hear in upcoming months, it may be important to stay focused on the basic issues.

Like this:

John Ameriks

John Ameriks oversees the Active Equity Group within Vanguard Equity Investment Group, which manages active quantitative equity fund assets. He is one of Vanguard's thought leaders on retirement issues and has conducted studies on a wide range of personal financial decisions, including saving, portfolio allocation, and retirement income strategies. John came to Vanguard in 2003 from the TIAA-CREF Institute, the research and education arm of TIAA-CREF. He graduated from Stanford University with an A.B. and earned a Ph.D. in economics from Columbia University.

Comments

Anonymous | November 26, 2009 2:43 pm

Yes it’s true “Roth is not an iron clad guarantee of no future taxes” and “tax laws can change”. But why not consider the possibility of changes to the tax treatment of traditional IRA’s: RMD’s could be increased. The age at which RMD’s start could be lowered. A surtax could be implemented on Trad. IRA’s that have “more than a fair share” of retirement assets. Maybe I haven’t thought of all the possibilities.

Do you trust a future congress, desperate for revenue, to honor the past promises with respect to traditional IRS’a?

Anonymous | November 26, 2009 10:54 am

For those people who contributed after-tax money into a traditional IRA in the past, it may make a lot of sense to convert a large portion of that traditional IRA to a Roth IRA while the opportunity is available. This is especially true if no pre-tax money had been contributed, so taxes would only need to be paid on any growth that has occurred. There is a possibility that most of the money in the traditional IRA will not be taxable during the conversion if the IRA had lost a significant portion of its growth during the recent bear markets.

Even if taxes on growth are imposed in the future, there would be no significant loss due to changes in the tax laws, and there is a good chance that all of the money in the IRA would grow completely tax free.

Anonymous | November 25, 2009 1:39 pm

Let’s say I am sitting on a combination of unused short and long term capital losses that I can carry over from previous years. Can I use some or all of those losses to offset income taxes owed on traditional IRAs converted to Roth IRAs next year? Does your answer differ if those traditional IRAs have a large non-deductible IRA component? Thanks!

Anonymous | November 24, 2009 12:02 pm

Many past changes to tax laws governing retirement savings have included grandfathering clauses. An example would be the tax reform act of 1988 where previously 403(b) plans had no withdrawal restrictions. The 12/31/88 balances were grandfathered to continue to have no withdrawal restrictions. Post 1988 contribtions and earnings are subject to the restrictions we know today. In considering whether or not future Roth distributions might become taxable, it is reasonable to think there will be some form of a grandfathering clause. Roth investments should not be discounted as a sound retirement planning tool becuase of a fear that the Gov. may impose a tax sometime in the future.

Anonymous | November 24, 2009 12:16 am

For those considering converting the funds now in a traditional IRA to a Roth IRA ,what about the losses that occur due to the compounding that doesn’t take place because of the taxes that must now be “rendered” ? When I think about this and the possibility of our “Benevolent Uncle” changing his mind about no taxes ever during retirement, I am somewhat inclined to ” look the gift horse in the mouth”. Am I on the wrong track here?

Anonymous | November 23, 2009 5:52 pm

The problem I worry about as a 70’s plus senior with a regular IRA is that the RMD gets larger each year, putting me in a higher and higher tax bracket. Even though I gained a tax advantage putting the money into the IRA, the tax I avoided was much less than the tax now due on the RMD. How does all this factor into the wisdom of conversion to Roth?

Anonymous | November 20, 2009 11:30 pm

Anonymous | November 20, 2009 5:52 pm

Mr. Ameriks, I appreciate your caution that tax laws change and there is no ironclad guarantee that qualified distributions from a Roth IRA will continue to be free of income tax. Most commentators fail to communicate that warning. I think it is very likely that eventually there will be a surcharge, or a tax on earnings, or a tax to the beneficiary. The appetite of government for more power and control over the lives of citizens is boundless.

Anonymous | November 20, 2009 5:51 pm

The key point was made in the first of your three points- ‘the Roth is not an iron clad guarantee of no future taxes’. Do you trust a future congress, desperate for revenue, to honor the past promise of no taxes ever on a Roth? They will pontificate and then in the name of ‘fairness’ decide that the Roth was too generous a ‘gift’ and tax the proceeds. If you convert you will pay taxes now- that is certain. Whether it will be tax free in the future is not. There seems to be a certain wisdom in defering taxes as long as possible. As with all investment decisions there is an up-side and a down-side. In this case the downside (taxes on the conversion) is certain, the upside (future tax freedom of the proceeds) is not.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.